Liquid Plumber

Location: New York
Author: Ira Artman
Date: Tuesday, January 27, 2009

If you’re trying to source our current distress, pick up Professor John Taylor’s recent working paper – The Financial Crisis and Policy Responses: An Empirical Analysis of What Went Wrong.

Taylor examines thoroughly and in great depth, i.e., plumbs, alternative theories for the crisis. He then devises tests to determine which theories are consistent with empirical data. He concludes by observing:

Government actions and interventions caused, prolonged, and worsened the financial crisis.

This article provides my quick summary of Professor Taylor’s work. You should read his original paper for the full story.

Impact of Loose Monetary Policy

According to Professor Taylor, monetary excesses were the main cause of the US housing boom and bust. This can be seen if one compares:

1) The actual path for the Fed Funds rate, from 2001 – 2006; with

2) An alternative path for Fed Funds that would have been consistent with prior Fed policies that produced good US economic performance.

Figure 1: Actual and Alternative (“Counterfactual”) Fed Funds Paths

The Economist, 18 Oct 2007

As indicated in Figure 1, between 2001 and 2006, actual interest rates were well below levels suggested by historical relationships – evidence that monetary policy was “too easy” – the Fed provided too much liquidity. Professor Taylor observes that:

There [had been] … no greater or more persistent deviation of actual Fed Policy [from that implied by the Taylor rule] since the turbulent days of the 1970’s.

Professor Taylor then provides the results of an empirical model that focuses upon what the housing market might have looked like had Fed Funds been higher and followed a path consistent with prior policy. The figure appears below.

In Figure 2, the jagged solid line depicts actual housing starts, and the smooth “Counterfactual” line depicts starts produced by a model using the higher, Taylor Rule, rate path.

Finally, the smooth higher line depicts housing starts produced by a model using the actual Fed Funds path. Professor Taylor believes that this figure provides empirical evidence “that the unusually low interest rate policy was a factor in the housing boom.”

Impact of Monetary Policy & GSE Accommodation Upon Subprime Mortgage Originations

The low interest rates, identified in Figure 1, then contributed to excessive risk taking in the subprime mortgage market through their impact upon mortgage credit.

Figure 3: Home Prices and Subprime Delinquencies

As suggested by Figure 3, subprime credit varies inversely with home prices. The home price boom contributed both to unusually robust subprime credit performance, and also “threw the [somewhat backward-looking subprime] underwriting programs off track.” This produced loose underwriting policies that became much too lax as the housing boom progressed.

Professor Taylor also singles out the GSEs’ appetite for “risky sub-prime mortgages” as an additional contributing factor. Taylor’s view is shared by Nobel laureate Harry Markowitz, as I observed in One At A Time:

There has been, for a long period of time, considerable pressure by Congress on Fannie Mae to support the objective of low-cost housing. The only way to satisfy that was for Fannie to lower their standards. And once they lowered their standards, others had to do the same to be competitive…

Professor Harry Markowitz, One At A Time, Nov 2008.

Event Study: September - October 2008

The most controversial section of the paper may be Professor Taylor’s “event study” – a close examination of market reaction to federal policy announcements from September to October, 2008. The event study relies upon a graph (his Figure 13) of short-term credit spreads.

Professor Taylor maps movements in credit sensitive spreads to market events as well as Treasury and Fed policy announcements. The key date appears to be 23 Sep, when a “2-1/2 page draft of [TARP] legislation with no mention of oversight and few restrictions” was released. Credit spreads quickly quadruple. This may reflect:

Public realization that the intervention plan was not “fully thought through”; and/or
General public dissatisfaction with the arbitrary and unclear rationale for government market intervention or inaction with respect to failing financial institutions.

Conclusion

Professor Taylor sums up his brief by stating:

Government actions and interventions caused, prolonged, and worsened the financial crisis;
They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for 20 years…;
They made it worse by providing support for certain financial institutions … but not others in an ad hoc way without a clear and understandable framework…
These government actions should be first on the list of answers to the question of what went wrong.

Citing a need for a “massive [policy] clean-up,” Professor Taylor calls for a return to principled and proven interest rate policies, clarity, and predictability with respect to government intervention. Let’s hope that these changes occur.

REFERENCES

John B. Taylor, NBER Working Paper 14631 - The Financial Crisis And The Policy Responses: An Empirical Analysis of What Went Wrong, Jan 2009.

The Economist - Fast and Loose, 18 Oct 2007.

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